Gary Thomas, White & Case, Tokyo

Gary Thomas, White & Case, Tokyo
Sam Sim, Standard Chartered Bank, Singapore Clemens Thyme, S&P Capital IQ, Hong Kong Michael Quigley, White & Case, Washington DC TRANSFER PRICING IN ASIA: THE GROWING ACCEPTANCE OF THE ARM’S LENGTH PRINCIPLE Asia Tax Forum 2012 Raffles Hotel, Singapore May 9-10, 2012

TOPICS INTRODUCTION MATURING OF THE ARM’S LENGTH PRINCIPLE IN JAPAN: A LESSON FOR THE REST OF ASIA? COMPETENT AUTHORITY AND TRANSFER PRICING: HOW IS IT WORKING IN ASIA? CURRENT TRANSFER PRICING ISSUES IN FINANCIAL SERVICES TRANSFER PRICING – CREDIT RISK ASPECTS CURRENT ISSUES BEING RAISED IN LITIGATION CUSTOMS AND TRANSFER PRICING: WHAT YOU SHOULD BE AWARE OF FUTURE OF TRANSFER PRICING IN ASIA QUESTIONS

I. INTRODUCTION Introduction of Panelists
Overall Panel Topic: “Growing Acceptance of the Arm’s Length Principle” in Asia Merits – The Arm’s Length Principle is accepted! Demerits – The Arm’s Length Principle (whatever it is) is required! Using Japan as an Example of How Application of Arm’s Length Principle Has Evolved Over Time Competent Authority: Is It Working in Asia? Special Challenges in Financial Services Applying the Arm’s Length Principle to Intra-Group Loans and Guarantees Recent Litigation Issues Transfer Pricing and Customs

II. MATURING OF THE ARM’S LENGTH PRINCIPLE IN JAPAN: A LESSON FOR THE REST OF ASIA
Outline Historical Background Recent History Application of the Arm’s Length Principle Over the Years Advance Pricing Arrangements New Transfer Pricing Enforcement Approach in Japan: Focus on Taxpayer Voluntary Compliance Japan as a Lesson for the Rest of Asia?

Historical Background of Transfer Pricing Enforcement in Japan
Adoption of Transfer Pricing Rules in 1986 Reaction to US Internal Revenue Service assessments against US subsidiaries of major Japanese corporations from early 1980s Transfer Pricing Rules Take Effect in 1987 Initial NTA Enforcement Policies ( ) Collection of Information by Survey “Soft Touch” Enforcement Approach Adoption of “Centralized Management” by International Examination Section in NTA Early Japanese Transfer Pricing Cases Focused on Foreign-Based Firms ( ) Expansion of Focus Toward Japanese Firms’ Outbound Transactions (from 1996) Impact of APA Program in Recent Years in Reducing Number of Audits Continuing Aggressive Audit Activity Impact of Introduction of Transfer Pricing Documentation Requirements in 2010

Recent History in Transfer Pricing Compliance Rules
Release of NTA Transfer Pricing Guidelines (2001) Addition of Transfer Pricing Provisions for Consolidated Corporations (2002) Requirement of Disclosure of Transfer Pricing Methodologies in Schedule 17-3 (2003) Introduction of Transactional Net Margin Method (“TNMM”) (2004) Expansion of Coverage of “Foreign Related Parties” (2005) Introduction of the Profit Methods (TNMM and PSM) in Presumptive Taxation (2006) Introduction of Tax Payment Suspension Regime Specifically for Transfer Pricing Assessments in Competent Authority (2007) Expansion of Exchange of Information Rules (2009) Codification of Transfer Pricing Documentation Requirements (2010) Introduction of “Most Appropriate Method Rule” (2011)

Transfer Pricing Assessments Since FYE 1999
Historical Chart of Transfer Pricing Assessment in Japan since FYE 1999 (Source: NTA Press Release) *Each fiscal year shows FYE June XXX

Threshold Question: Is Comparability of “Transactions” to be Based on Single Transactions or Groupings of Transactions? Historical NTA Position: Singular and strictly transactional, with aggregations within product group or business segment permitted in limited circumstances “where setting of price is performed taking into consideration transactions belonging to same product group …or same business segment” Use of “mini-baskets” in practice – but no overall company comparisons were accepted Historical NTA Position: There is only one arm’s length price. Japanese transfer pricing law does not recognize ranges But, in recent practice, NTA accepts overall company comparisons and considers the use of ranges

Comparable Uncontrolled Price Method
Early application of secret comparables based on “single transaction” interpretation Failure of NTA to disclose identity of comparable product, comparable transaction or comparable company – “secret comparables” Taxpayer was prevented from performing an effective comparability analysis. Failure to make appropriate adjustments for differences in commercial level, transaction volume and other factors, such as business strategies Subsequent difficulty to sustain secret comparables in competent authority negotiations Use of CUP now seems to be the exception.

Resale Price Method Singular or Plural?
NTA officials originally interpreted the Resale Price Method provisions as referring to “transactions” in the “singular,” resulting in application on a strictly transactional, “product-by-product” basis, with no aggregations of products and transactions recognized. Criticisms of strict transactional approach Taxpayers without “internal” comparables could not use the Resale Price Method unless they could identify (from information on competitors) specific gross margins of specific competing products which are similar to the Taxpayer’s products (and will be considered “similar” by the NTA on audit) and make necessary adjustments for differences in functions or other matters in regard to such specific transactions. Requires use of “secret comparables” by tax authorities Gradual adoption of company-wide comparison approach Ultimately, difficult to sustain in competent authority negotiations NTA now accepts company-wide comparison approach and has become more flexible in applying the Resale Price Method

Profit Split Methods Early preference for profit split methods in US/Japan competent authority cases Development of conceptual arguments for applying profit splits Early criticism of “one-sided” approaches and concern for “income creation” NTA Guidelines instruct examiners to compare Japanese profits vs. foreign profits In past, NTA favored “contribution profit split” and use of two factors indicating relative value added: depreciation expense and personnel expense Critics argue that Japanese Contribution Profit Split fails to take into account the value of intangible property embedded in products provided by foreign suppliers. NTA has also used advertising and promotion expenses and other selling expenses of Japanese subsidiary of foreign based firm, resulting in high allocations of overall profits to Japan.

Profit Split Methods (cont’d)
NTA adopted “residual profit split” and “comparable profit split” by circular based on OECD Transfer Pricing Guidelines NTA sometimes applied Residual Profit Split but ignored contracts and legal ownership to attribute high value to alleged “marketing intangibles” in Japan. More recently, NTA has favored use of Residual Profit Split on outbound intangible transactions of Japanese companies Document requirements included disclosure of foreign segment profit-and-loss data. Recent defeat in court case involving profit splits

Transactional Net Margin Method
NTA historical antipathy toward TNMM History of US assessments against Japanese firms based on Comparable Profits Method (CPM) and “income creation” issue Active Japan involvement in drafting OECD 1995 Transfer Pricing Guidelines paragraphs limiting use of TNMM Gradual acceptance from late 1990’s of “modified resale price method” to resolve MAP cases and reach bilateral APAs TNMM finally adopted into Japanese tax law in 2006 Policy objective seemed to be to apply to Japanese firms’ outbound transactions. But adoption occurred at same time as agreement to revise US/Japan income tax treaty TNMM was positioned as an “other method” with lesser priority than RPM or other basic methods

Transactional Net Margin Method (cont’d)
NTA was reluctant to apply TNMM in transfer pricing audits just after its introduction in 2004 But from 2006 or so, NTA increasingly accepted TNMM in bilateral APAs and unilateral APAs and later on in audits as well TNMM was included as a presumptive taxation method in 2006. It is expected that TNMM will be applied more extensively going forward, although tax authorities’ views on comparables will likely be different from those of taxpayers.

Seeking Certainty: Advance Pricing Arrangements Become More Prevalent
Advance Pricing Arrangements (APA) confirm that, once a tax authority evaluates the transfer pricing methodology and its validity, and accepts them as reasonable, as long as the firm conducts transactions according to the contents under certain preconditions, there would be no taxation on transfer prices. Principal merits and demerits Merit: Secure predictability in transfer pricing Merit: Mitigate the transfer pricing risks (presumptive taxation, secret comparables and penalty) Merit: More flexibility in applying methods as compared to an audit Demerit: Required to submit much information to tax authorities for APA review, which can be like an audit Demerit: Administrative burdens and expenses On balance: Should now be seriously considered!

Trends in Bilateral APAs in Japan
Increasing number of APA applications (Source: NTA Press Release)

Increased number of APAs with Asian countries (Source: NTA Press Release)

Significant increase in application of TNMM in recent years (Source: NTA Press Release)

New Transfer Pricing Enforcement Approach: Voluntary Compliance as a Matter of Corporate Governance
Public announcement at a Tax Seminar in Tokyo on April 24, 2012 Mr. Toshiyuki Fushimi, Director, Large Enterprise Examination and Criminal Investigation Department National Tax Agency of Japan International Trends in Tax Enforcement Efforts to Enhance Corporate Governance Concerning Taxes Efforts to Maintain and Enhance Tax Compliance in Transfer Pricing Key Actions Expected of Enterprises to Prevent Occurrence of Transfer Pricing Problems “Check Sheet to Confirm the Status of Efforts Concerning Transfer Pricing”

International Trends in Tax Enforcement: Meeting of the Forum on Tax Administration in January 2012
The January 2012 meeting in Buenos Aires of the Forum on Tax Administration brought together the heads of the tax administrations from 43 countries under the auspices of the OECD and concluded with a unified and strengthened commitment to combat offshore tax abuse. The tax administrators focused on the need to work smarter in times of shrinking budgets, and how to strengthen their relationship with large corporations through efficient and effective strategies that benefit both the taxpayer and taxing authority. “Although there have been some high-profile successes in the fight against offshore tax abuse, resulting in significant additional tax revenues and real improvements in transparency and exchange of information, it is far too soon to declare victory.” The tax administrations agreed that collaboration must now include coordinated actions by countries to finally put an end to offshore non-compliance.

International Trends in Tax Enforcement: Meeting of the Forum on Tax Administration in January 2012
A key agreed objective was to promote the relationship between tax administrations and Large Business Taxpayers “An adversarial relationship between tax administrations and multinational corporate taxpayers serves neither of our purposes well and is contrary to our common goals, which are earlier and greater certainty, consistency, and efficiency.” “We will pay particular attention to the process of conducting and resolving transfer pricing cases. Overall, we intend to move away from a hide and seek approach to one based on greater transparency on the part of both taxpayers and tax administrations. As more companies put good tax compliance at the heart of their corporate governance, this will be easier to achieve.”

International Trends in Tax Enforcement: OECD Guidelines for Multinational Enterprises - 2011
Part I : Recommendations for responsible business conduct in a global context Section XI - Taxation “Tax compliance includes such measures as providing to the relevant authorities timely information that is relevant or required by law for purposes of the correct determination of taxes to be assessed in connection with their operations and conforming transfer pricing practices to the arm’s length principle.” (Para 1) “Enterprises should treat tax governance and tax compliance as important elements of their oversight and broader risk management systems. In particular, corporate boards should adopt tax risk management strategies to ensure that the financial, regulatory and reputational risks associated with taxation are fully identified and evaluated.” (Para 2)

Part I, Section XI - Taxation In the case of enterprises having a corporate legal form, corporate boards are in a position to oversee tax risk in a number of ways. For example, corporate boards should proactively develop appropriate tax policy principles, as well as establish internal tax control systems so that the actions of management are consistent with the views of the board with regard to tax risk. (Para. 102) Tax authorities may need information from outside their jurisdiction in order to be able to ….. determine the tax liability of the member of the MNE group in their jurisdiction. Again, the information to be provided is limited to that which is relevant to or required by law for the proposed evaluation of those economic relationships for the purpose of determining the correct tax liability of the member of the MNE group. MNEs should co-operate in providing that information. (Para. 103)

Part I, Section XI - Taxation Application of the arm’s length principle avoids inappropriate shifting of profits or losses and minimises risks of double taxation. Its proper application requires multinational enterprises to cooperate with tax authorities and to furnish all information that is relevant or required by law regarding the selection of the transfer pricing method adopted for the international transactions undertaken by them and their related party. (Para. 104) The OECD Transfer Pricing Guidelines aim to help tax administrations (of both OECD member countries and non-member countries) and multinational enterprises by (partially omitted) minimising conflict among tax administrations and between tax administrations and multinational enterprises and avoiding costly litigation. Multinational enterprises are encouraged to follow the guidance in the OECD Transfer Pricing Guidelines, as amended and supplemented, in order to ensure that their transfer prices reflect the arm’s length principle. (Para. 106)

Efforts to Enhance Corporate Governance Concerning Taxes
“From the perspective of the maintenance and improvement of the level of tax reporting throughout Japan, it is important to maintain and improve tax compliance by large business taxpayers.” The economic activities of large business taxpayers occupy a large portion of the economy in Japan and the amount of their reported income is high. For example, large business taxpayers comprise 0.02% of the number of corporations, but 26% of the reported income of all corporations. Large business taxpayers lead industries and regions. Tax compliance by large business taxpayers greatly affects tax compliance by their enterprise groups as well as small to medium taxpayers and individual taxpayers. When the tax compliance by large business taxpayers, which require significant administrative resources in tax examinations, is enhanced, the tax administration will be able to allocate more administrative resources to the corporations with a high level of need to be examined and to plan for improvement in their level of reported income.

Results of Enhancing Corporate Governance Concerning Taxes
“It is beneficial for both enterprises and the tax administration when tax compliance is improved through the enhancement of corporate governance.” Benefits for Enterprises Minimizing tax risks Minimizing the burden of audit defenses in tax examinations. Benefits for the Tax Administration Greater focus on tax examinations of corporations with a high need for examinations

Efforts by the National Tax Authorities*
“The national tax authorities will maintain and improve tax compliance through the enhancement of corporate governance by large business taxpayers, by confirming the status of corporate governance concerning taxes by large business taxpayers during tax examinations and carrying out exchanges of views with top management.” 1. Conducting of Orientation Sessions “In meetings attended by top management of large business taxpayers, we will encourage the enhancement of corporate governance concerning taxes (such as by introducing examples of effective efforts).” * “National tax authorities” refers to regional taxation bureaus, which have jurisdiction over large business taxpayers.

Efforts by the National Tax Authorities
Approaches towards Individual Enterprises During the opportunity of a tax examination by Special Examiners in the Large Enterprise Examination Department in each regional tax bureau, the national tax authorities will confirm the status of the corporate governance concerning taxes by large business taxpayers through a request to them to describe the current status of their corporate governance including the involvement and direction by top management and the maintenance of an organization and functions in the finance and audit departments, in a “Confirmation Sheet on Corporate Governance Concerning Taxes”. Upon the closing of a tax examination, the top management of a large business taxpayer and the top officials of a regional tax bureau will exchange views for the enhancement of corporate governance concerning taxes (such as by introducing examples of effective efforts).

Efforts by the National Tax Authorities
3. Use in Determining the Need for an Examination “Going forward, when determining the need for an examination, the national tax authorities will utilize the status of corporate governance concerning taxes as an important decision-making material and will allocate tax examination resources more heavily toward corporations with a high need for an examination.” Efforts in Transfer Pricing “Also on transfer pricing, in order to maintain and improve tax compliance, the national tax authorities will carry out a detailed plan as part of its efforts for the enhancement of corporate governance concerning taxes.”

Efforts to Maintain and Enhance Tax Compliance in Transfer Pricing
“In order to prevent the occurrence of problems concerning transfer pricing, the national tax authorities will promote the voluntary and appropriate actions of enterprises through cooperation between the national tax authorities and the enterprises.” Merits for both the enterprises and the tax authorities through maintaining and enhancing tax compliance in transfer pricing Benefits for enterprises Minimizing tax risks Minimizing the burden of audit defenses in tax examinations Benefits for the tax authorities Greater focus on tax examinations of corporations with a high need for an examination Preventing the problem of international double taxation (Mutual Agreement Procedures with foreign tax authorities)

Particular Compliance Concerns in Transfer Pricing
In a self-assessment system, the taxpayer is required to themselves calculate the arm’s length prices for their transfer pricing and to file tax returns based on such calculations. Because transfer pricing issues involve huge risks and costs, it requires even more voluntary and appropriate actions by the enterprises. The importance of improving tax compliance, including transfer pricing, has been highlighted as an international trend. In foreign countries, the enforcement of transfer pricing rules has been strengthened, and it is expected that transfer pricing assessments (double taxation) and the competent authority negotiations resulting from the same will increase. Accordingly, there is an increased need to consider measures, etc. for advance prevention of double taxation.

Particular Compliance Concerns in Transfer Pricing
Currently, the national tax authorities are moving ahead with efforts toward the enhancement of corporate governance concerning taxes, and it is possible to characterize the measures for transfer pricing as one part of such efforts. In addition, in the 2010 tax reforms, the scope of required transfer pricing documentation was clarified, and the environment for the preparation of transfer pricing documentation was improved. This means that the “documents that are recognized to be necessary for the purpose of computing arm’s length prices” were clarified in the ministerial order that sets for the “presumptive taxation” rules, which could be invoked if the tax administrations are not able to obtain the taxpayer’s cooperation through providing such necessary documents.

Key Actions Expected of Enterprises to Prevent Occurrence of Transfer Pricing Problems
Knowledge of Transfer Pricing Legislation Involvement of Top Management Recognition of Status and Problem Areas in Foreign Related Party Transactions Implementation of Global Transfer Pricing Policies Transaction Price Setting Taking into Account Transfer Pricing Methodologies Transfer Pricing Compliance of Related Parties Overseas (Governance by Parent Company) Communications with the Tax Administration Based on the above, a “Check Sheet to Confirm the Status of Efforts Concerning Transfer Pricing” should be prepared.

Efforts to Maintain and Improve Compliance in Transfer Pricing
“As part of their efforts directed toward the enhancement of corporate governance concerning taxes, the national tax authorities will encourage enterprises to themselves plan for the maintenance and improvement of tax compliance in transfer pricing, while confirming the status of the efforts of the enterprises concerning transfer pricing.” Facilitation through Orientation Sessions “Along with an explanation of the domestic and foreign trends in transfer pricing, the national tax authorities will explain the importance for enterprises to themselves maintain and improve their tax compliance in transfer pricing.”

Efforts to Maintain and Improve Compliance in Transfer Pricing
Facilitation through Individual Contacts with Enterprises The national tax authorities will confirm the status of efforts on transfer pricing through a request to fill in a “Check Sheet to Confirm the Status of Efforts Concerning Transfer Pricing.” As the time of exchanges of views between the top management of the enterprises and the tax bureaus with regard to corporate governance concerning taxes, the national tax authorities will also exchange views concerning transfer pricing. Views will be exchanged between the enterprises and the tax officials in charge of transfer pricing, based on the contents of the “Check Sheet to Confirm the Status of Efforts Concerning Transfer Pricing.”

Japan as a Lesson for the Rest of Asia?
What can we learn from Japan’s history of attempting to apply the Arm’s Length Principle using the various transfer pricing methods? What have the Japanese tax authorities told other governments in Asia over time and now today about Japan’s experience? What are the implications of Japan’s new transfer pricing enforcement approaches seeking greater taxpayer compliance based on corporate governance objectives?

III. COMPETENT AUTHORITY AND TRANSFER PRICING: HOW IS IT WORKING IN ASIA?
Panel Discussion Gary Thomas, White & Case, Tokyo Sam Sim, Standard Chartered Bank, Hong Kong Clemens Thyme, S&P Capital IQ, Hong Kong Michael Quigley, White & Case, Washington DC

IV. CURRENT TRANSFER PRICING ISSUES IN FINANCIAL SERVICES IN ASIA – THE BIG PICTURE
IPO Volume 2011 Financial Sector FDI 2011 CROSS-BORDER bank lending to Asia’s developing economies has been shrinking recently. European banks in particular have been retrenching as they seek to meet new capital targets. That may prompt many borrowers to turn instead to the capital markets—as they did during the last financial crisis. European bank lending to emerging Asia fell by over a fifth in the year to March In response, firms in these countries issued a flurry of bonds: over $240 billion in 2009, compared with $122 billion the year before. Asia's growing bond-markets may provide a useful "spare tyre" in a region that still mostly bounces along on bank lending.

Some Macro Factors Impacting Level of Cross-border Activity
IV. CURRENT TRANSFER PRICING ISSUES IN FINANCIAL SERVICES IN ASIA – CONTRASTING FLAVOURS Some Macro Factors Impacting Level of Cross-border Activity Crisis, really? European withdrawal vs Regionals Stepping up Bank Finance to Capital Markets Simpler Products vs Increasing Sophistication Increased Regulations vs Internationalization Ring-fencing liquidity vs Outlet for excess savings Asia cross-border FS has vast room for growth But so does sophistication of authorities & TP rules ! Indonesia upgraded, Myanmar opening up Japanese/Australian Fis, CIMB, DBS Trade, local MNCs going abroad, natural resources, financial center aspirations, opening up –Myanmar, Vietnam, open up domestic markets

IV. CURRENT TRANSFER PRICING ISSUES IN FINANCIAL SERVICES IN ASIA – DIFFERENT STROKES
A. Familiar Global Themes… Challenge to management fees/Head-office charges Related party lending, capital, liquidity and guarantee fees Increased documentation & reporting/compliance burden Regulatory change and restructuring B. More so in Asia… Intervention/influence of prudential regulators Sophistication of tax authorities, advisors and taxpayers - Target vs Principles based; Cultural aspects Bespoke & evolving business/product/pricing models Legislative framework is young and in flux (Treaties/APA/MAP, TP jurisprudence) Beyond OECD?: BRIIC, UN model Implications of state ownership Top 3 Asia ex-Japan Loans Mandated Arranger for 1Q12 Bloomberg are State Bank of India, China Development Bank and Bank of China. Top sovereign wealth funds 6 out of 11 – 4 from China, SAFE Investment Company, China Investment Corporation, HKMA, National Social Security Fund, GIC and Temasek. Abu Dhabi and Kuwait Investment Authority, Australia future fund. UAE – Abu DhabiAbu Dhabi Investment Authority$ Oil5NorwayGovernment Pension Fund – Global$ Oil10ChinaSAFE Investment Company$567.9**1997Non-Commodity4Saudi ArabiaSAMA Foreign Holdings$532.8n/aOil4ChinaChina Investment Corporation$ Non-Commodity7KuwaitKuwait Investment Authority$ Oil6China – Hong KongHong Kong Monetary Authority Investment Portfolio$ Non-Commodity8SingaporeGovernment of Singapore Investment Corporation$ Non-Commodity6SingaporeTemasek Holdings$ Non-Commodity10RussiaNational Welfare Fund$149.7*2008Oil5ChinaNational Social Security Fund$ Non-Commodity5QatarQatar Investment Authority$ Oil5AustraliaAustralian Future Fund$802006Non-Commodity10

IV. CURRENT TRANSFER PRICING ISSUES IN FINANCIAL SERVICES IN ASIA - MORE SPICE TO THE POT
A. APA/MAPs -Are they worth the trouble? -First in class? Do you have the resources? B. Reconciling Differences -Different TP methods and mark-ups; Global consistency vs Local appropriate -Tax/TP vs Accounting (Financial vs Management view) C. GAAR, Thin-Cap, Indirect Taxes & TP -Interaction of such evolving tax principles with transfer pricing D. Branch banking to Subsidiaries -Subsidarisation, Securities companies, SPEs E. TP Infrastructure -Tax vs Finance: Roles & Responsibilities -Outsourcing

TRANSFER PRICING – CREDIT RISK ASPECTS
Transfer pricing standards require financial transactions such as loans and guarantees between related entities to utilize arm’s length pricing. Key question: At what rate could a subsidiary fund itself if it were an independent entity?

Establish a Risk Based Framework for Intercompany Loans and Guarantees
Use a risk based approach that differentiates credit quality Find appropriate comparable market rates for interest spreads or guarantee fees Use globally consistent methodology Document sound economic theory around assessments Example: Coca-Cola Data = rated debt market transactions

Classification - Credit Assessment Methodologies
Sector, Size Input Output Advantage Limitation Public and Private Ratings All 3 years financials, management meeting Rating Easy to access and interpret Additional coverage through Private Estimates Limited coverage No standalone assessments of subs - Costs of Individual assessments Credit Scorecard Current Quantitative and Qualitative Data Score that can be mapped to a rating - Comprehensive sector coverage (Corp, FI, Ins) Requires qualitative & quantitative analysis If outsourced, cost of individual assessment Credit Model – rating score US$ 20-50M and above Current Quantitative Data Quantitative and objectified information only Large numbers of subs can be assessed quickly Links to Ratings data Limitation in sectors, as some are hard to quantitatively model and size over USD c20m Credit Model - PD SME (US$1M and above) Probability of Default Direct and quantified default measure Smaller entities with USD 1-100m revenue - Requires comprehensive empirical datasets including local/regional default data, which is hard to obtain Ratings Internal or Third Party Standard & Poor’s established the Risk Solutions group at the beginning of the year to… With 140 years of credit assessment experience to build on, you won’t be surprised to hear our focus is on credit. In the area of credit risk we provide custom services and tools to build, improve and evaluate internal credit risk practices

Build fundamentals driven comparables
Establish consistent approach for internal ratings on subs: Model based approach (most objectified, limitations) Internal Ratings Based approach (most detailed, expensive) Internal vs. external assessment Generate custom comparable yield curves 46

Alternatives in Establishing Effective Reference Prices
Establishing a market based comparable requires: Transparent methodology Appropriate segmentation (geography, industry, credit rating, duration, etc.) Cover all risk factors (sovereign risk, T&C) Strong grounding on empirical data Credit Spread Models 47

VI. CURRENT ISSUES BEING RAISED IN LITIGATION AND WHAT THIS MEANS FOR ASIA
Status of Selected Recent Cases US: Medtronic Inc. v. Comm’r US: Guidant LLC v. Comm’r, T.C. No US: Veritas Software Corp. v. Comm’r US: Xilinx, Inc. v. Comm’r US: Intersport Fashions West Inc. v. United States Australia: SNF (Australia) Pty. Ltd. v. Comm’r Canada: GlaxoSmithKline Inc. v. The Queen Canada: The Queen v. General Electric Capital Canada Inc. Canada: Alberta Printed Circuits Ltd. v. The Queen India: Vodafone Spain: Roche Vitamins Europe Ltd. Russia: Gazprom Extraction Astrakhan LLC Toyota Argentina SA c/AFIP-DGI What These Cases Mean for Asia

Medtronic Inc. v. Comm’r, T.C. No. 6944-11
SUMMARY: Leads and devices adjustment: $1.2 billion The IRS challenged payments from Medtronic Puerto Rico (“PR”) to Medtronic U.S. for the use of patents and other IP and to purchase medical device components. PR used the components to assemble finished products, which it sold to Medtronic USA Inc., another U.S. affiliate that distributed the products in the U.S. and abroad. Medtronic used a CUT as its primary method, with a profit split as a corroborating method. IRS argument in the alternative: significant value transferred under 367(d) Medtronic also challenges a royalty true-up in the amount of $4 Swiss Supply Agreement Issue: $39 million Under the agreement, Medtronic’s Swiss subsidiary assists PR by manufacturing and supplying the U.S. with devices to meet excess U.S. demand. The Swiss subsidiary pays the leads and devices royalty and the trademark royalty that PR would have paid if it had manufactured the product itself.

Spinal Screw Operations: $90 million Medtronic claims that the IRS improperly treated its PR as a contract manufacturer rather than a risk-bearing, autonomous manufacturer Interest Income from Prior Buy-In Case: $14 million In 2010, Medtronic and the IRS signed a closing agreement to resolve a 2008 Tax Court case (Medtronic Inc. v. Comm’r, T.C. No ) relating to the buy-in paid by Medtronic’s Swiss subsidiary for the right to use preexisting intangibles. Medtronic disputes the inclusion of the interest amounts in its returns because it has a competent authority request pending pursuant to the U.S.-Switzerland treaty.

STATUS: Medtronic Inc. filed a petition in the Tax Court on March 23, 2011, challenging $2.7 billion in upward income adjustments to its 2005 and 2006 taxable years. Approximately $1.4 billion of the adjustments were transfer pricing adjustments related to licensing and manufacturing transactions with Medtronic’s affiliates in Switzerland and Puerto Rico. The case is currently scheduled for trial on May 21, 2012 in the Tax Court, although the parties have moved for a continuance.

Guidant LLC v. Comm’r, T.C. No. 5989-11
SUMMARY: Like Medtronic, involves licensed IP and manufacturing arrangements: Guidant’s Irish affiliate purchased components from Guidant U.S. and used the components to manufacture units that generate pulses in pacemakers Guidant Ireland sterilized and packaged the finished products, then sold them back to Guidant U.S., foreign related parties, and third-party distributors IRS challenged royalties for use of licensed intangibles, prices of components, and intercompany sales of finished products in transactions with Irish and Puerto Rican affiliates The IRS used a CPM and concluded that a cost plus 13.9 percent markup (Puerto Rico) and a cost plus 11 percent markup (Ireland) should be applied to labor and overhead The IRS did not calculate a markup on other costs Guidant claims that the IRS did not specify the portions of the adjustment attributable to the individual affiliates As in Medtronic, the IRS argued in the alternative that the transferred intangibles should be taxed under Section 367(d).

Guidant LLC v. Comm’r, T.C. No. 5989-11
STATUS: Guidant LLC, which was acquired by Boston Scientific Corporation in 2006, filed a petition in the Tax Court on March 11, 2011, challenging $1 billion in transfer pricing adjustments to its 2001 and 2002 taxable years. The adjustments related to technology licenses and manufacturing arrangements between Guidant U.S. and its subsidiaries in Puerto Rico and Ireland. The case is currently pending in the Tax Court and is scheduled to be tried on June 18, 2012.

Veritas Software Corp. V. Comm’r, 133 T.C. 297(2009)
SUMMARY: Valuation dispute over Veritas U.S.’s buy-in payment under a cost-sharing arrangement (“CSA”) from its Irish subsidiary. Veritas U.S. reported a $166 million lump-sum buy-in payment from Veritas Ireland on its 2000 return. In 2002, Veritas U.S. amended its 2000 return to reduce the payment to $118 million. During audit, the IRS proposed an adjustment to increase the buy-in to $2.5 billion but at trial, the IRS reduced the proposed buy-in to $1.675 billion. In Veritas Software Corp. v. Comm’r, 133 T.C. 297 (2009), the Tax Court held for the Taxpayer Upheld the Taxpayer’s use of CUTs to value the contributed intangibles

On December 6, 2010, the IRS issued an Action on Decision, AOD , I.R.B. The IRS declined to appeal the Tax Court decision but characterized it as erroneous IRS announced that it will continue to litigate cost sharing cases using approaches to valuation that distinguish between make-sell rights (to pre-existing intangibles) and platform rights (to technology developed in the future)

Issue was valuation of intangibles conveyed in a CSA Veritas U.S. contributed pre-existing computer software programs to the CSA, including the right to further develop the programs. Veritas used CUTs to value the intangibles contributed to the CSA using licenses to unrelated original equipment manufacturers such as HP and Dell The IRS rejected comparables as involving make-sell rights to preexisting intangibles rather than platform rights to future developed intangibles Court accepted licenses as comparables under a functional, rather than contractual, analysis The IRS valued the intangibles as having perpetual useful lives and in the aggregate, rather than individually Treated the contribution as “akin to a sale” of Veritas U.S.’s business to its Irish affiliate Court rejected this approach

Xilinx, Inc. v. Comm’r, 598 F.3d 1191 (9th Cir. 2010)
SUMMARY: Issue was proper cost base to be used in a qualified cost-sharing arrangement (“QCSA”) for Xilinx’s taxable years The Tax Court held in favor of Xilinx. Xilinx, Inc. v. Comm’r, 125 T.C. 37 (2005). In Xilinx I, 567 F.3d 482 (9th Cir. 2009), the Ninth Circuit reversed in favor of the IRS. In Xilinx II, 598 F.3d 1191 (9th Cir. 2010), the Ninth Circuit withdrew its opinion in Xilinx I and affirmed the Tax Court’s decision in favor of the taxpayer. The IRS issued an Action on Decision, AOD , I.R.B , in which it acquiesced in result only because the 2003 amendment of the regulations rendered the decision moot for subsequent years.

Xilinx, Inc. v. Comm’r, 598 F.3d 1191 (9th Cir. 2010)
While a QCSA between Xilinx and its Irish subsidiary was in effect, Xilinx granted stock options to its employees, which they exercised. The IRS claimed that stock-based compensation should have been included in the cost-sharing pool. Xilinx’s position was that uncontrolled parties engaging in comparable transactions would not share the cost of the stock options. Competing rules: Cost-sharing rules provided that QCSA participants must share “all costs” But the arm’s length standard is a general standard to be applied “in every case” Xilinx I: held for IRS Cost-sharing rules were specific rules that trumped general Section 482 rule Xilinx II: held for Xilinx Resolve ambiguity by looking at: Purpose of regulations – parity between controlled and uncontrolled transactions Consistency with U.S.-Ireland treaty

Veritas and Xilinx after the 2011 Cost-Sharing Regulations
STATUS: In April 2012, the IRS warned that taxpayers entering into CSAs should not rely on Veritas or Xilinx now that the final 2011 cost-sharing regulations are in force. “As we transition to the 2008 temporary and 2011 final cost-sharing regulations, we will be moving beyond the reach” of Veritas and Xilinx. - Joseph Tobin, IRS Office of Associate Chief Counsel (International) (published in Tax Notes Today, April 23, 2012). Citing the Supreme Court’s decision in Mayo, the IRS has said that its new cost-sharing regulations were specifically and intentionally drafted to resolve the issues raised in Veritas and Xilinx. In Mayo, the Supreme Court held that Treasury regulations that have been subject to a notice and comment period are entitled to Chevron deference.

Intersport Fashions West Inc. v. United States, 2012 TNT 30-21 (Fed. Cl. 2012)
SUMMARY: Subsidiary of German motorcycle apparel company not permitted to claim refunds for restructuring expenses incurred by its parent because the expenses were not claimed on a timely filed return. STATUS: Government prevailed on motion for summary judgment – a taxpayer cannot affirmatively invoke Section See Treas. Reg (a)(3).

SNF (Australia) Pty. Ltd. v. Comm’r, [2010] FCA 635
SUMMARY: SNF Australia, decided on June 25, 2010, is the Federal Court of Australia’s first written guidance on the application of the transfer pricing methods in Australia. Facts: SNF Australia imported polyacrylamide products from affiliates in France, the U.S., and China, and then sold these products to Australian customers. SNF Australia used the CUP method, with sales of products by SNF France to non-Australian third parties as comparables. SNF Australia reported losses back to 1998 despite evidence of sales growth. SNF Australia explained these as resulting from poor management, high levels of competition, low sales per salesperson, and excessive stock levels. The Australian Tax Office used the TNMM (with an operating profit of 1.7 percent) to adjust SNF Australia’s income upwards. The Australian Tax Office challenged SNF Australia’s use of the CUP, arguing that the French sales were not comparable. The Court rejected the use of the TNMM, faulting it and other profits-based methods for “inevitably attribut[ing] any loss to the pricing” The Court accepted SNF Australia’s CUP analysis and its evidence demonstrating that the losses were caused by poor management and not by its transfer prices The Australian Tax Office appealed the decision to the Full Federal Court.

SNF (Australia) Pty. Ltd. v. Comm’r, [2011] FCAFC 74
STATUS: On June 1, 2011, the Full Federal Court dismissed the Commissioner's appeal. The Court conducted a re-examination of much of the evidence presented by the taxpayer to support its pricing under the CUP method and concluded that, in light of the following factors, comparability had been established: characteristics of the property the functions (activities of the companies conducting the comparable transactions) the contractual terms and conditions in the comparable transactions economic circumstances of the markets in which the transactions took place and Business strategies of the respective parties The Court concluded that there was a single global market, leading to its acceptance of comparable data from different geographic markets. In its Decision Impact Statement dated November 7, 2011, the ATO narrowly interpreted the impact of the Court’s decision. The ATO also alluded to proposed legislation to reform the transfer pricing rules, in which case the legal position would probably be materially different.

GlaxoSmithKline Inc. v. The Queen, [2010] FCA A-345-08
SUMMARY: On July 26, 2010, the Federal Court of Appeal issued a taxpayer-favorable decision in GlaxoSmithKline. At issue were Glaxo’s Canadian subsidiary’s payments to a related Swiss distributor for the active pharmaceutical ingredient in Zantac during the company’s taxable years. Glaxo used the resale price method, which produced prices ranging from $1,512 - $1,615 The Canadian tax authorities used the CUP method, which produced prices ranging from $194 - $304 using prices paid by unrelated generic manufacturers for the same ingredient. The Tax Court of Canada largely upheld the assessments. On appeal to the Federal Court, Glaxo argued that a license agreement, by which it used the Zantac trademarks, must be considered in evaluating its transfer prices. Glaxo’s position was that no third party could sell Zantac without the license agreement The CRA argued that only the supply agreement should be considered in determining what was “reasonable in the circumstances.”

GlaxoSmithKline Inc. v. The Queen, [2010] FCA A-345-08
The Federal Court of Appeal upheld the use of the CUP but agreed with Glaxo that the valuation must consider the license agreement and all other relevant circumstances. The Tax Court of Canada largely upheld the assessments. The Federal Court of Appeal upheld the use of the CUP but adjusted the pricing determination to account for the Zantac brand name. STATUS: The Supreme Court granted the parties’ motions for leave to appeal and cross appeal and the appeal was heard on January 13, 2012. During the hearing, several judges asked whether it made a difference that the active ingredient purchased by Glaxo Canada was to be marketed and sold as “Zantac,” a branded product that would yield a higher retail price than the generic product. The Chief Justice asked about bundling and its relationship to transfer pricing – if the price included something other than the substance (IP), why was withholding tax not remitted? A decision is not expected before the end of the year.

The Queen v. General Electric Capital Canada Inc., [2010] FCA 344
SUMMARY: On December 15, 2010, the Federal Court of Appeal upheld the Tax Court of Canada’s taxpayer-favorable decision in GE Capital Canada Inc. (“GECCI”). Facts: GECCI is a financial services company doing business in Canada. It financed much of its business with debt guaranteed by its U.S. parent company. Beginning in 1995, GECCI paid a guarantee fee of 1% of the principal amount of the debt outstanding during the year to its U.S. parent. GECCI deducted the guarantee fees in its 1996 through 2000 tax returns, totalling approximately $136.4 million in deductions The CRA disallowed the deductions, claiming that the 1% guarantee fee exceeded an arm’s length price. The Tax Court of Canada held for the taxpayer, finding that the U.S. parent’s “implicit support” should be taken into account in determining the guarantee fee.

The Queen v. General Electric Capital Canada Inc., [2010] FCA 344
The Federal Court of Appeal upheld the Tax Court’s decision: Held that “implicit support” must be taken into account in evaluating transfer prices because an arm’s length party “standing in the shoes” of the taxpayer would consider it relevant. STATUS: The CRA is attempting to re-litigate the case after denying General Electric Canada Company (“GECC”), successor by amalgamation to GECCI, a deduction for these same fees paid to the U.S. parent corporation. ( (IT)G and (IT)G). In December 2011, the Tax Court denied GECC’s motion that res judicata prevented the re-litigation of this issue. Although the issues are similar, the Tax Court denied the motion because there are different taxpayers and different tax years involved.

Alberta Printed Circuits Ltd. v. The Queen, 2011 TCC 232 (June 2011)
SUMMARY: APC manufactured custom circuit boards for customers in Canada and the U.S., and for several years many of the design and setup services were performed by a Barbados company controlled by a key employee of APC. The founders of APC and the key employee had interests in both APC and the Barbados company, but there was no common legal control of the two entities. STATUS: However, the Tax Court held that the two companies did not factually deal with one another at arm’s length and were thus subject to Canada’s transfer pricing rules.

India – Vodafone Int’l Holdings B. V. v
India – Vodafone Int’l Holdings B.V. v. Union of India (Supreme Court, Jan. 20, 2012) SUMMARY: Vodafone, a U.K. telecommunications company, purchased an Indian mobile phone company from a Hong Kong-based company for $11.2 billion in 2007. Indian tax authorities assessed $2.2 billion in capital gains tax against Vodafone in connection with the transaction, claiming that The Bombay High Court ruled in favor of the CBDT in 2010. STATUS: In January 2012, the Supreme Court reversed, holding that in the absence of a specific look-through provision in India’s domestic law, a sale of shares by companies outside of India cannot be taxed by India simply because the underlying assets are located in India. The Supreme Court stated that allowing taxation under these circumstances “would amount to imposing capital punishment for capital investment since it lacks authority of law.”

India – Vodafone Int’l Holdings B. V. v
India – Vodafone Int’l Holdings B.V. v. Union of India (Supreme Court, Jan. 20, 2012) AFTERMATH: On February 17, 2012, Indian tax authorities filed a petition with the Supreme Court requesting a review of the January decision. The Supreme Court rejected the petition on March 20, 2012. However, in March 2012 the government proposed amendments to the Income Tax Act that would permit the retroactive taxation of cross-border transactions involving assets located in India. Separately, in December 2011, Vodafone was subject to a $1.7 billion transfer pricing assessment in India. It recently filed an appeal citing certain favorable observations in the above-mentioned Supreme Court decision.

Roche Vitamins Europe Ltd, Supreme Court of Spain, Case No
Roche Vitamins Europe Ltd, Supreme Court of Spain, Case No. 1626/2008 (Jan. 11, 2012). SUMMARY: The Supreme Court affirmed the National Court’s holding that Roche Europe, a Swiss company, had a PE in Spain through its “stripped risk subsidiary,” Roche Spain. Roche Spain was a contract manufacturer receiving a cost plus 3.3 percent markup and also served as a sales representative for Roche Europe, for which it received a commission of 2 percent of sales in Spain. Roche Spain had no authority to negotiate the terms of sale or to conclude contracts, it merely represented, protected, and promoted the interests of Roche Europe. The National Court concluded (and the Supreme Court affirmed) that although Roche Spain’s facilities were not a “fixed place of business” of Roche Europe, Roche Spain was a dependent agent because it was legally and economically dependent on Roche Europe, which both directed and controlled all relevant activities of Roche Spain and bore all economic risks associated therewith.

Roche Vitamins Europe Ltd, Supreme Court of Spain, Case No
Roche Vitamins Europe Ltd, Supreme Court of Spain, Case No. 1626/2008 (Jan. 11, 2012). TRANSFER PRICING : The Supreme Court also addressed the “attributable income” issue, which has transfer pricing implications. Practitioners typically argue that , even if there is a PE in a country from which risk has been stripped, a transfer pricing analysis would conclude that the fees allocated to the stripped-risk affiliate are adequate to compensate it for its “routine” functions. But the Court held that Roche Spain was not adequately compensated for all of the functions it was performing for Roche Europe. The Court concluded that product sales in Spain were taxable to Roche Europe’s PE and Roche Spain should take into account a portion of European sales for this it had assisted in promotion. The Court held that. under Paragraph 34 of the OECD Commentary to Article 5, once a PE is established, it exists to the extent that the agent acts for the principal, not only to the extent of the agent’s contracts. As a result, all of the economic activity conducted by Roche Spain on behalf of Roche Europe is part of the PE.

Gazprom Extraction Astrakhan LLC, Federal Arbitration Court (Russia), Case No. KA-A40/ (June 2011) SUMMARY: The Russian tax authorities attempted to apply the “net-back approach” (an adjusted CUP method) to Gazprom’s sales of sulfur to a related party outside of Russia. STATUS: The court rejected the Russian tax authorities attempt because the method is not mentioned in the Russian Tax Code’s transfer pricing article.

Toyota Argentina SA c/AFIP-DGI, Argentina National Tax Court (April 28, 2011)
SUMMARY: The tax authorities had retroactively applied new transfer pricing rules to reject the taxpayer’s transfer pricing study and methodology. STATUS National Tax Court found for the taxpayer and revoked a notice of deficiency.

VI. CURRENT ISSUES BEING RAISED IN LITIGATION – WHAT IT MEANS FOR ASIA
Is Litigation a Viable Method for Managing Transfer Pricing Risks? Are transfer pricing disputes about the facts, the applicable law and/or the “economics?” Can courts be expected to find the “right answer?” What about the path forward after litigation? Impact of Litigation Elsewhere on Transfer Pricing in Asia Precedential value? Highlighting issues for potential local enforcement? Greater likelihood of litigation in the courts to resolve disputes?

VII. CUSTOMS AND TRANSFER PRICING: WHAT YOU SHOULD BE AWARE OF
Customs Taxes: Valuation methods – transfer pricing rules vs. customs valuation rules “Arm’s length price” under OECD TP guidelines as acceptable “transaction value method?” “Resale price method” vs. deductive value method” “Cost-plus method vs. “constructed value method” Joint OECD/WCO conferences in 2006 and 2007 “Transfer pricing” – OECD, tax advisors and industry representatives “Customs” – WCO, country representatives, customs advisors 2006 – optimism for convergence between the two sets of rules; but in 2007, did reality set in? “Transfer pricing” positions “Transfer pricing rules” acknowledge “modern” transactions involving tangibles, intangibles and services, while “customs” valuation rules are item-based and “old school.” ‘Transaction values” supported by OECD “arm’s length pricing” study should be accepted as showing no related party influence, so customs officials should accept “arm’s length pricing” adjustments or at least accept some mechanism to consider same. “Customs” reactions Importance of well-accepted customs rules adopted on multilateral basis under GATT Skepticism of “profit methods” in transfer pricing Most inter-company transactions are accepted under “transaction value” method anyway. Specific challenge: Use of profits-based method (e.g., TNMM) that requires prospective or retroactive pricing adjustments to reach profit targets. Acceptable for customs? What procedures? Any convergence in transfer pricing and customs practices in Asia countries?

VIII. FUTURE OF TRANSFER PRICING IN ASIA
Where are we headed during the next 5 years? PANEL DISCUSSION “Most Appropriate Method” Rule Use of Comparative Methods vs. Profit Methods Documentation Requirements Enforcement Approaches Cooperation Among Tax Authorities Litigation MAPs and APAs Transfer pricing and customs

IX. Q & A Questions?

Thank you for your attention

Gary Thomas, White & Case, Tokyo

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